While the home improvement category will not suffer the most from market loss, it is likely it will affect earnings at Bunnings

HNN Sources

A joke, popular in the 1960s, tells of an alien spacecraft that arrives above Earth. After several months of the giant craft hovering over New York City, Earth scientists work out a way to communicate with the aliens. But what question should the aliens first be asked? After a month of polling, referendums, newspaper editorials and debate, a single question suitable for this "First Contact" is established. In a small room beneath the huge dish antenna aimed at the alien craft, a white-coated scientist finally pecked at a keyboard, typing in the query "Coke, or Pepsi?"

The point is, of course, that whenever a culture encounters anything essentially a little alien to it, the first instinct is to interpret whatever it is in terms of how it will affect that culture. This is only natural, but it does leave to one side an equally important question: how will this new thing itself regard the culture with which it is set to interact?

That has certainly been the case as regards the US online (mostly) retailer Amazon, which is set to establish a physical, warehouse-based presence in the Australian market, possibly near the end of November 2017 (though this may be limited at first). While there have been numerous commentaries published on how Amazon might affect Australian retailers and consumers, there has been much less written about how Amazon sees itself and views its coming interaction with the Australian consumer market.

Also, much of what has been written has often varied between raw speculation and conclusions based on apparently either non-existent or very poor research. In particular, we've seen this lack of rigour in what has been reported of discussion at some forums specifically related to retail.

Amazon was, apparently, much discussed The Australian Financial Review Retail Summit held in Sydney in early November 2017. Relying on reports on this event from the Australian Financial Review (AFR), we can roll through some of the objections raised as to why Amazon will somehow falter when it enters Australia.

Australia is like Canada, Amazon did not do well in Canada (initially), so Amazon will not do well in Australia

An interesting thesis that seems a bit thin when you look at the actual facts.

Looking back to calendar 2015 (when the comparison was still a little relevant, as Amazon has increased Canadian sales over the past two years), Canada had an estimated USD24 billion in online sales, while Australia (using Roy Morgan figures) had USD29.5 billion in online sales.

That said, population density is similar, with Canada's overall average four people per square kilometre, and Australia's three people per square kilometre. The population of the three largest cities is also similar: Toronto has 5.9 million, Sydney 5.0 million; Montreal has 4.1 million, Melbourne 4.7 million; and Vancouver has 2.5 million, matching closely to Brisbane at 2.4 million.

However, when you consider that Canada's population is 50% higher than Australia's, it's evident Australia has a far higher degree of urban concentration. You can add to this that the distance between Vancouver and Montreal is around 4500km, and the distance from Brisbane to Melbourne is around 1600km. The spread of that arc is obviously going to affect logistics.

Additionally, Australia has a higher GDP per capita than Canada, and a lower unemployment rate as well.

So, Australia has much higher per-capita online sales, higher earnings per capita, more relative employment, and higher relative urban concentration, with its three major cities in an arc about 40% the size of the comparable arc in Canada. Roy Morgan figures indicate online sales for Australia in 2017 are 10% higher than they were in 2015. It is difficult to see how one could compare the environment Amazon encountered in Canada three or four years ago, to the environment in Australia today.

This is a conclusion that is not limited to HNN's analysis. Respected investment analyst Craig Woolford of Citibank has reached a similar conclusion:

Despite differences in economic development, we see five common elements across Amazon's international markets: high internet penetration and share of retail sales in e-commerce channels; modern IT and telecommunications infrastructure; strong logistics infrastructure; high income per capita; and experience selling products in the targeted market.

Whatever retailers may be saying to each other publicly, it's apparent that those supporting the "Australia is Canada" argument do not seem to have provided much in the way of supporting facts.

Finally, while Amazon did start slowly in Canada, its impact is now being felt. To quote from one Canadian news source commenting on the influence of the US online retailer:

Old-guard retailers are furiously transforming their business models in an attempt to compete against the Seattle-based online giant, while analysts and investors are scouring quarterly sales figures, wondering if any retailers will be immune to Amazon's corrosive impact on sales and profits.

Amazon doesn't know what it faces when it comes to dealing with unions in Australia

The AFR reported that it was suggested Amazon might not be aware that it would be dealing with Australia's Transport Workers Union, and that, as one participant put it, "this could be fairly exciting for them."

It is worth noting that Amazon throughout much of its 20-year history has had dealings with the US International Brotherhood of Teamsters union. This is one of the largest unions in the world, and the 11th largest US political campaign contributor.

Recently, Amazon has had a dispute with the Teamsters over the working conditions of the contracted pilots flying Amazon-owned Boeing 767s. A typical engagement would be the 2016 dispute in Los Angeles California:Amazon's dispute with the Teamsters union

Further, the person whom Amazon has appointed country manager for Amazon Australia, Rocco Braeuniger, was formerly with the company's German operations, and has dealt extensively with unions there. German unions are certainly regarded as some of the more communicative and collaborative in the world, but they are also, politically and in the workplace, some of the most powerful.

It's also worth noting that the person backing him up, Fabio Bertola, who is head of Amazon Marketplace for Amazon Australia, worked at Amazon in Italy for a year, and has three years of in-country Australia experience working for the Winning Group, which runs Appliances Online, as well as other websites.

In line with the above comment, HNN has also seen some comparisons of warehouse labour costs in the US being substantially lower than in Australia. Some of these report wages of USD9.00 an hour. Glassdoor, a service which helps rank US employers for jobseekers, estimates Amazon pays an average USD12.00 an hour. According to the US Bureau of Labor Statistics, the mean hourly wage is for this type of work (classification code 43-5071) is USD15.94, while the median is USD14.99 (goo.gl/G3EJ9X). It is likely, however, that Amazon pays in the lower 25% percentile, where the wage averages out to USD12.11.

According to salary comparison site indeed.com, the Australian average for work of this type is $25.02 an hour, which equates to USD19.20 or so. However, it is notable that employers such as Harvey Norman are listed by indeed.com as paying around $20.44 an hour (goo.gl/noieG8). It would not be surprising to see Amazon secure a similar rate in its employment contracts, which would bring its hourly wage cost down to USD15.64 per hour, an increase of 30% on its US wages.

Offsetting that is the fact that the warehouse facilities that Amazon builds in Australia will be, in its second round of expansion, as fully automated as any that Amazon owns, which will radically reduce the number of workers being utilised, and likely result in a wage for productivity result around 8% to 12% higher than that of the US. If you add in a further decline in the AUD to USD exchange rate, likely by a further 5% during 2018, it is difficult to see how fullfilment costs will be such an overwhelming issue.

Amazon will abuse its global market power to run at a loss for several years, and the Australian Government will step in to prevent "dumping".

According to a report in the AFR, the head of the Australian Competition and Consumer Commission (ACCC), Rod Sims, said:

In terms of misuse of market power, if you open a store in a new town and you set a common price point, you are going to lose money initially if you don't have scale. Eventually if you get your business plan right you will make money at that price point, that is in no way illegal.... It is not illegal if Wesfarmers do it with a Coles supermarket in a new town and it is not illegal if Amazon comes in and sets a price point that only makes money at a certain scale.

That would seem to scotch rumours of intervention by the ACCC, for the first three years or so, at least. But what about elsewhere in the Government? While everyone from small business ombudsman Kate Carnell to small business minister Michael McCormack have made the expected statements about looking over Amazon's shoulder, it seems unlikely that anything other than minor discussions would be held.

It is worth thinking about the reasons why Amazon will likely be running at something of a loss initially. It's not just price and margin, it's also considerable investment in infrastructure, estimated at $700 million. That will no doubt include the construction of custom warehouse facilities, most likely in regional or exurban areas, where there is substantial low employment.

It's a little bit difficult to imagine the Federal Government making moves to inhibit the development of a company that is spending big on construction, technology, and adding jobs in regions where they are needed the most.

More than that, though, pricing at Amazon is not driven so much by super-discounting products, but more by placing immense pressure on suppliers, and picking up unexpected deals on a global basis.

The Amazon effect: how much, and where?

In the US, online shopping is being credited with a considerable decline in key areas of physical retail. In terms of overall marketshare, Amazon seems big, but not huge. It is estimated that online retail accounts for around 10% of overall US retail, and that Amazon is expected to show it holds 43% of that online revenue for calendar 2017. Some estimates suggest that over half of all product searches begin on Amazon in the US. Contrast that with, for example, Wal-Mart stores' share of the USD800 billion US grocery market, which is estimated to be 21.5% in 2017.

The scary part for US online retailers is that the 2017 numbers for Amazon represent an overall increase of over 5% in net market share, or growth for Amazon of 14%. Meanwhile, its closest competitor in revenue terms, eBay, is expected to slip from 7.8% marketshare in 2016 to 6.8% in 2017, while Apple will pick up 0.4% to hit 3.6% marketshare, and Walmart will add 0.8% to also reach 3.6%.

In the US Amazon holds a 41% marketshare of online men's apparel sales, according to One Click Retail (goo.gl/4Ub1nJ), and a 36% share of women's apparel sales. The growth aspect comes through in other areas, however, such as baby apparel, where Amazon's 2017 Q3 sales hit USD50 million, up from USD30 million in the previous corresponding period (pcp), an increase of 67%.

Amazon is not so much a marketshare story, as a growth story, with a potential for continued growth that cannot be matched by competitors, even in a market where those competitors have spent big on developing online services. Estimates currently predict Amazon will hold 50% of all online sales in the US market by 2021. And that seems, to some, a pessimistic forecast.

European market

What about outside of the US? It is estimated that online sales in the UK reached GBP60.43 billion during calendar 2016, and that Amazon accounted for GBP7.3bn of those sales, which equates to a 12% market share.

In Germany, overall online retail sales are estimated at EUR52.7 billion for calendar 2016, and Amazon's share of that is estimated at EUR12.8 billion, which delivers a 24% marketshare.

Amazon in Australia

There has been a great deal of dispute over exactly how much impact Amazon will have on the Australian market, especially over its first two to three years of operation. One number that has gained some credence was suggested by Mr Woolford. He estimates the company could attract around $4 billion in online sales by 2022, which would equate, according to projections, to around 12% of the online retail market, and 1.1% of the overall retail market.

Mr Woolford has highlighted, in particular, the effect of Amazon on retailers in the electronics industry, such as JB HiFi. Results from a May 2017 survey conducted by Nielsen seeking to explore Australian consumer attitudes to Amazon back up his assessments. The three top categories where consumers expressed interest were: Electrical/electronic items (60%); books (54%); and clothes (46%). Nielsen results from May 2017 survey

As some commentators have pointed out, the real risk to established Australian businesses is unlikely to peak in those first five years, but to rapidly increase in the subsequent five. That is what is indicated by Amazon's experience in the UK and other worldwide markets, including Germany.

Hardware category effects

Of course, what is of prime interest is what effect Amazon may have on the home improvement category. Some commentators have suggested that this may be minimal, due to the nature of home improvement, which features relatively high delivery costs, and often a "hands on" aspect that other categories - such as electronics - do not.

A good source to check on this subject is One-Click Retail, which has published some statistics on Amazon's presence in the US, UK and German markets. This can be accessed at:One-Click Retail statistics on Amazon

Certainly, the largest home improvement retailer in the US, The Home Depot, would disagree with that assessment. Home Depot has shifted its business model quite radically over the past three to four years, moving most of its expansion spending from physical stores to building the infrastructure needed to boost its online business. Ecommerce sales for Home Depot reached USD5.6 billion in 2016, up from USD4.7 billion in 2015, an increase of 19.5%, and representing 6% of overall company revenue.

In terms of the US, the overall home improvement market for 2016 was estimated at USD313 billion, up by 6% over 2015. Amazon's share of that market is estimated at USD5 billion. The real figure of interest here, however, is in terms of growth: that market grew by 35% for Amazon from 2015 to 2016.

The four top growth categories were handtools, up 40%, power tool accessories, up 25%, safety equipment, up 20%, and woodworking tools, up 30%. In terms of individual products, door knobs and lock sets grew by 45%, fasteners and hooks by 45%, lighting controls (such as dimmer switches) by 85%, and kitchen/bath tapware by 30%.

In case this seems like a "US-only" situation, it's not. In the UK, Amazon achieved an estimated GBP300m in sales in the GBP36 billion overall home improvement market, which is over 8%. Again, though, the real story is growth, as Amazon grew its revenue by 20% over 2015.

In Germany 2016 online home improvement sales reached EUR600 million, in a market worth around EUR40 billion, or a roughly 1.5% marketshare. Growth, however, was a highly positive 45% over 2015 figures.

Estimates

It is not possible to generate a single number that would indicate how much marketshare in home improvement Amazon will eventually win in Australia. Some estimates put this at around 2%, which would accord with Mr Woolford's estimate of $4 billion in what could by 2021 be a $80billion market. However, HNN would point to the fact that there are few if any real competitors online to Amazon in home improvement, and that those which exist are unlikely to develop an effective response until after they have suffered significant losses. We therefore think a better estimate would be between 2.5% and 3.0% of the market in the 2021/22 financial year.

Leading up to that, based on past experience, what we can likely expect is considerable noise and excitement over Christmas in 2018, followed by slightly disappointment in 2019, with the real effect of Amazon first taking hold in 2020. This means that Australian retailers who will be affected would be advised to develop plans over the next two years, or face having to catch up to Amazon for several years thereafter.

Effects

While many independent hardware stores will feel some effects some two to three years after Amazon's entry, there is little doubt about the retailer that will experience the most effect of its business: the Wesfarmers' owned Bunnings.

There are a number of reasons for this. The two main ones are that Bunnings is far more reliant on the consumer/DIY trade than most independent retailers, and that it has made its low prices part of its major attraction to consumers. To take one category, power tools, Amazon already has good international relations with major companies such as Bosch, Makita and Stanley Black & Decker. While these are sold directly by Amazon, it appears that tools from Techtronic Industries (TTI), such as Milwaukee and Ryobi, are sold through Amazon by third-party sellers.

Doing a price comparison indicates that with suppliers such as Bosch, Amazon does, on some specific tools, enjoy a considerable price advantage. From example, the Bosch DDB181-02 drill driver kit (charger, case, two 2.0 amp batteries) retails on Amazon for USD99, while it sells at Home Depot (online-only, not in-store) for USD159.

Effectively, what is likely to happen is that, just as today many DIYers will check the price of a tool on the Bunnings website before buying it elsewhere, they will start to check with both Bunnings and Amazon Australia in the future.

It is worth mentioning that there is another area of potential competition as well. Amazon has been building out its offering in terms of helping to sell the services of Amazon approved installers for products sold through Amazon. These approved quotes appear as part of the sales process for products such as large wallscreen TVs. Amazon goes through an extensive approval process in certifying these installers for its website, and monitors customer feedback closely. This could have an impact on budding services services such as Home Improvement Pages (HI Pages) and Oneflare, which attempt to offer services to match homeowners with tradies.

Reactions

HNN has spent considerable time over the past three years trying to work through the puzzle of Bunnings and online ecommerce. Our end conclusion has been that, as an organisation, Bunnings is simply not built for online. What it does well is to build good physical stores, encourage people to visit those stores, and to sell those people a basket of items from which it derives a workable margin.

In particular, it is a retailer that tries to avoid making things complex as much as it possibly can. Even if complexity offers additional margin, it will prefer to stick with systems and strategies where execution can be easily controlled.

Online, from Bunnings' perspective, has two main disincentives: it would likely lower overall margins, and it would introduce the complexity of delivery and other logistical systems. Additionally, there is the possibility that by entering online commerce at this point, Bunnings would be acting as a "pathfinder" for Amazon, establishing a market which the US-based retailer could then leverage to market its own products.

However, there is another possibility. If we look at the experience of Kingfisher in the UK market, that home improvement retailer really did not "get" online retail until it experienced the runaway success of its Screwfix brand. Screwfix continues to be the real growth story in a slightly declining UK market, though much of its recent growth has come from leveraging its well-developed online reputation to build a successful physical presence.

What if Bunnings also went down the sub-brand route when it comes to online commerce? As an example, suppose Bunnings chose to take its Ozito captive brand, and to develop a website that sold that brand of power tools exclusively?

This has a number of advantages. It terms of the stocking/picking/dispatch logistics, having a single supplier reduces complexity considerably. Given its control over margins for this brand, Bunnings could offer online goods at a discount to in-store purchases. That's particularly useful for the Ozito range, as it virtually defines "price sensitive" for power tools. A reduction of $5 off a $95 drill is enough to act as a "buy" trigger for many consumers in this market. With an exclusive brand, price competition with other websites is much less of an issue. When it comes to expensive matters, such as returns, Bunnings could also effectively leverage its physical store presence.

It's a tactic which utilises established strengths, and some of in-place investments, in a way that at least minimises complexity. It would enable Bunnings to develop a better understanding of online commerce, in an environment that reduces capital expenditure and risk as compared to a more general rollout. With at least six major captive brands in different areas, it also offers the potential for future expansion.

Amazon Marketplace

HNN has so far skipped over a large section of what Amazon has to offer, namely the third-party Amazon Marketplace (AM), where retailers have the option of selling goods through the Amazon site, with Amazon optionally looking after the logistics of picking and sending.

One of the real benefits of this service is for small suppliers and product developers who have a great idea they cannot get larger retailers to stock. It offers a near-instant means of achieving market presence. Some retailers in the US and elsewhere also use AM as a means of off-selling overstocks, or testing new products to gauge demand.

One of the more interesting aspects, however, is a burgeoning market for specialised sellers who concentrate on doing nothing else except AM, and don't care particularly which products they are selling. Instead they concentrate on finding a product where they can beat the Amazon price (if it exists) and the prices offered by other AM sellers. If they achieve the best product plus shipping price, they will "cream off" all the orders for that product.

In the US, this has opened up sources of secondary supply. That includes companies that have over-ordered some lines and need to clear warehouse space, and also, of course, grey market goods. It will be surprising, for example, if the Australian AM doesn't see some goods come in from South-East Asian markets that bear a familiar brand name, but are sold for much less.

This could also influence the online home improvement market. What happens, for example, if a trader buys a lot of reconditioned cordless Milwaukee or Ryobi tools, then offers those for sale on the Australian AM?

Analysis

Amazon certainly will face unique conditions on entering the Australian market. It seems somewhat unlikely, however, that these conditions will be any more exotic than those the company faced in entering the French, German, Italian or UK markets. HNN would also guess that they are nowhere near as exotic as those the company faced in entering the Japanese market (a country where Amazon still struggles, despite having first entered it in 2000). Some of these conditions will no doubt cause small setbacks, but it's highly unlikely they will, in the end, have much influence over Amazon.

In general, much of the response of major Australian retail business to Amazon has attempted to portray its entry into the Australian market along the lines of a physical store retailer making the same move. Nowhere is that more apparent than in the repetition of the fact that Mr Braeuniger apparently revealed in a conversation in early 2017 that he was unaware of Australia's holiday penalty rates for retail workers. It seems somewhat germane to this point that Amazon, for at least its first two years of operations, is unlikely to employ any retail workers.

Equally ill-founded was a comment the AFR reported being made by a former senior Wesfarmers retail executive that Amazon's frequent change of prices would somehow not work in Australia as it annoys consumers. This approach has been central to the strategy that helped Amazon power its way to annual revenues of USD136 billion, and a market capitalisation of USD536 billion. The reality is, of course, that online what Amazon is doing is tracking the same prices consumers will see doing a Google search. It's simply making sure it stays in the running.

The Australian retail industry really has to come to terms with the fact that Amazon has arrived, and that it will, over the next decade, wreak considerable changes on the retail market. While it's possible to make some predictions about the next four or five years, predicting what Amazon will do out to ten years is much harder.

While home improvement will likely suffer less than many other categories in terms of competition with Amazon, it's worth noting that the two largest home improvement retail brands in Australia are owned by companies heavily reliant on revenues and profit from grocery retailing. In the end, the greatest effect on home improvement may come from Amazon disrupting that market, which is already under considerable stress.

It is also worth seriously considering what second-order effects of Amazon's entry will have on the home improvement market. If Bunnings or other major retailers respond to Amazon - such as by opening HNN's hypothetical Ozito online store - that may have greater consequences than Amazon itself. In stretching to ensure that it does not lose marketshare to Amazon, Bunnings could, in other words, take yet more marketshare from other retailers.